Operating Expenses - Part 2

Let's finish up the topic of Expenses this week. Last week I gave you the first 3 of the 6 major expense categories that make up the Operating Expenses (TIMMUR). They are; Taxes, Insurance and Management. This week I'll teach you about the last 3; Maintenance, Utilities and Repair.

I left in the spreadsheet right below this sentence as a refresher.


Scheduled Gross Income

-Vacancy

+Other Income

=Effective Gross Income (EGI)

-Operating Expenses (TIMMUR)

=Net Operating Income (NOI)

Now, let's look at the last 3 expenses.

Maintenance/Repair: Rather than getting into a long discussion over what the difference is between Maintenance and Repairs, I'll spend this time talking about the difference between R&M and Capital Expenditures, sometimes referred to as 'Cap Ex'. If you have a nagging desire to learn the exact difference between Maintenance vs. Repairs, call the IRS or just ask your CPA for their opinion.

Here are some things you'll find under the R&M category; cleaning the carpet, mowing the lawn, replacing a broken window, light bulbs, unclogging toilets, fixing a hot water heater or an AC unit, painting a unit, clean up of a unit, fixing a hole in the roof, replacing a faucet or toilet; pretty much anything that you would typically repair or maintain during the life of the property on a routine day in and day out basis. My CPA generally uses $1000 as his cut off. In other words, anything less that $1000 he'll typically categorize as R&M, anything over becomes Cap Ex.

Capital Expenditures are where things can get a little tricky. What if you repair a hole in a roof and the cost is over $1000? Talk to your own CPA. Mine will typically consider that a 'repair' even if it's slightly over $1000. However, if you replace an entire roof or all the roofs in the complex, that becomes a Cap Ex expense and the cost will need to be depreciated over time. Other items that would be considered Cap Ex would include replacing a boiler system, painting or re-siding the entire complex, redoing the landscaping, completing a major rehab project in which the individual pieces might all be less than $1000, but when added up costs tens or hundreds of thousands of dollars. The nice part is that Cap Ex doesn't affect the NOI of the property. Thusly, the value of your property doesn't drop due to some large expense like replacing the entire roof or rehabbing multiple units or the entire complex.

Another term you might hear when discussing R&M and Cap Ex is; 'Above the Line Expenses' and 'Below the Line Expenses'. What does this mean? Anything categorized as an 'above the line expense', means that it is considered part of your TIMMUR or Operating Expenses and it affects your NOI and the value of your property. Anything categorized as a 'below the line expense' is subtracted from your income AFTER you calculate your NOI. Thus, any major Cap Ex items are considered below the line which doesn't affect your NOI or value. Of course, it still does affect your cash flow.

Maintenance and Repairs combined will average between 5%-15% of EGI depending on the age of the complex and how long it's been since the last substantial rehab performed. Another factor that will affect where a complex will fall within this range is weather. Typically, properties that are in colder winter climates will drift towards the higher range. The warmer the climate, the lower it will generally gravitate.

Utilities will include, at minimum, the gas, electric, water and/or sewer costs for the property that are being billed directly to the owner/landlord. Of course, some or all of these charges may be for the expenses incurred on the common areas of the property like the hallways, leasing office, laundry room and landscaping. However, some may be charges incurred by the tenants themselves. Complexes that pay some or all of the Tenants' utilities are considered 'All Bills Paid' which means the owner pays for the utilities that the tenants use. The downside to this situation, which you've probably already figured out, is that you have little to no control over the energy consumption of your tenants. It's not uncommon to see a tenant's window open in the dead of winter with the heater running full blast. Most owners will try and do what they can to pass this expense onto the tenants. Sometimes that's not easy. You may or may not be able to charge a portion of the utilities back to the tenants. It really depends on what the market will bear and what's 'customary' in that market. Fortunately, most new owners are doing what they can to charge the tenants. If you do collect something from the tenants for their portion of the utilities, that 'Income' would be added to your 'Other Income' category above.

One way you can collect some or all of the money from the tenants for any utilities you pay on their behalf is through what's known as a RUBS or RUBBS. RUBS/RUBBS stands for Residential Utility Bill-Back System. As an example, let's say you pay for all of the electricity used on the property. One way to be 'reimbursed' from the tenants is to take the entire bill, divide it by the number of square feet on the property, multiply that number by the square feet of each unit, then give that amount on an invoice to the tenant based on their apartments size and have the tenant add the amount to that month's rent payment. There are several other ways you can accomplish the reimbursement process too, but I don't want to make this post too long.

Repairs: See Maintenance above

Let's recap. We started a few weeks ago learning about Effective Gross Income (SGI - Vacancy + Other Income = EGI). The last 2 lessons I taught you about the 6 major expense categories that make up our Operating Expenses or TIMMUR; Taxes, Insurance, Maintenance, Management, Utilities and Repair. You subtract the Operating Expenses from the Effective Gross Income (EGI) to arrive at your Net Operating Income (NOI).

Next week I'll teach you about Cap Rate. Cap Rate is one of the 2 key items you need to understand in order to calculate the value of your property. NOI is the other and you've been learning how to calculate your NOI over the past few weeks.